Tax Advice or Investment Advice:
Where Is the Line?
 

Editor:
Marc J. Minker, CPA/PFS
Managing Director, Private Client & Family Office Services
Mahoney Cohen & Company
New York, NY

Author:
Dick Fohn, CPA/PFS, CFP
Wealth Services Niche Chair
Moss Adams LLP
Bellingham, WA

For further information about this column, contact Mr. Minker at mminker@mahoneycohen.com, or Mr. Fohn at dick.fohn@mossadams.com..

A lot has changed in the accounting profession since the Investment Advisers Act of 1940 (Advisers Act). In the pursuit to add wealthy (and aging) clients, many traditional accounting firms have broadened their practices to include additional advisory services. However, such expansion has increased the possibility of running afoul of the investment adviser rules. More importantly, many firms and practitioners may be unwittingly providing information that today could be considered investment advice.

An essential starting point in avoiding such problems is a fundamental understanding of the Advisers Act and the Securities and Exchange Commission’s (SEC’s) rules and interpretations. However, seeking an opinion from legal counsel still remains the best approach to determine whether a particular service mix includes “investment advice” subject to the Advisers Act.

This column is a primer for assisting CPAs to better understand their responsibilities as advisers. It also presents examples of situations in which CPAs may be inadvertently providing investment advice. Because the issues related to the investment adviser regulation are quite complex, they are not fully addressed here.

The Broad Framework of the Advisers Act

Generally, CPAs must register with the SEC as an investment adviser if they fail a two-part test by answering “yes” to the following questions:

1. Is the CPA an “investment adviser”?

2. Has the CPA lost the “accountant’s exclusion”?

These two questions are related; in failing the second, the CPA may be in violation of the first. However, it is important to realize that the test has two parts. This distinction is lost on many in their pursuit of providing superior client service.

Who Is an “Investment Adviser”?

The definition of “investment adviser” may surprise many CPAs. According to Section 202(a)(11) of the Advisers Act, an investment adviser is:

Any person who, for compensation, engages in the business of advising others, either directly or through publications or writings, as to the value of securities or as to the advisability of investing in, purchasing, or selling securities, or who, for compensation and as part of a regular business, issues or promulgates analyses or reports concerning securities.

Traditionally, CPAs believe “investment advice” is limited to recommending a client take action on a specific, named security. An example would be, “I think you should buy X, because I think its P/E ratio is too low.” Clearly, this is investment advice. However, the definition in the Advisers Act, as well as in the SEC’s interpretations, is painted with a much broader brush.

Under the SEC’s interpretations, advice about the benefits or risks of investing in any type or class of securities is considered investment advice. For example, this would be the case if a CPA were to suggest to a client that some international exposure would serve as a hedge against domestic economic risk, or, alternatively, that a mix of small-, mid- and large-cap securities would be beneficial. According to the SEC’s interpretations, investment advice would also include an analysis of a client’s stock portfolio performance against a benchmark. Other probable investment advice is presented in the exhibit below.

One area of special concern is whether certain estate planning advice is investment advice. Conceptually, is there a substantive difference between advising a client to transfer assets to a family limited partnership (FLP) as an estate tax minimization strategy versus advising a client to invest assets in a real estate investment trust? Could the CPA argue that a closely held FLP interest is not a “security”? A closer look at Section 202(a)(18) of the Advisers Act reveals a definition of “security” so broad it would appear to include FLP interests:

“Security” means any note, stock, treasury stock, security future, bond, debenture, evidence of indebtedness, certificate of interest or participation in any profit-sharing agreement, collateral-trust certificate, pre-organization certificate or subscription, transferable share, investment contract, voting-trust certificate, certificate of deposit for a security, fractional undivided interest in oil, gas, or other mineral rights, any put, call, straddle, option, or privilege on any security (including a certificate of deposit) or on any group or index of securities (including any interest therein or based on the value thereof), or any put, call, straddle, option, or privilege entered into on a national securities exchange relating to foreign currency, or, in general, any interest or instrument commonly known as a “security,” or any certificate of interest or participation in, temporary or interim certificate for, receipt for, guaranty of, or warrant or right to subscribe to or purchase any of the foregoing.

A similar argument could be made for advising a client to transfer assets to a wholly owned entity. The advice would not constitute investment advice, because the control, nature and risks remain the same. This is sometimes referred to as the “closely held exemption.” Unfortunately, neither the Advisers Act nor the SEC interpretations recognize such an exemption.

Finally, another argument against CPA services constituting investment advice concerns estate planning advice that is fully tax-related. This argument may hold true under the accountant’s exclusion (discussed below) but, as will be shown, the exception is not without limits.

Presumption of Reliance

It could be argued that the nature of a client’s question, or the fact that a CPA is not a “traditional” investment manager (like a broker), makes it obvious that a recommendation is not investment advice. Under the principle of “presumption of reliance,” the CPA must presume the client is considering following the advice; otherwise, the question would not have been asked. For example, during a tax return interview, a client might ask: “Should I buy municipal bonds?” The CPA may assume the client is asking about the relative tax benefits of tax-free bonds versus taxable bonds. However, what the client may hear during the conversation is, “municipal bonds are right for you.”

CPAs must very carefully limit their response to a purely tax answer. Preferably, they should also follow up in writing to ensure that the client understood that the advice was not on the suitability of municipal bonds, for example, but, rather, merely on the associated tax benefits.

The SEC believes a CPA’s involvement in the selection, retention, management or reporting on the performance of a client’s investment managers also creates a presumption of reliance by the client, leading to the classification of these activities as investment advice. A person providing advice to a client on selecting or retaining an investment manager(s) would also be deemed, under certain circumstances, to be “advising” others within the meaning of Section 202(a)(11)6 of the Advisers Act.

Accountant’s Exclusion

The Advisers Act provides an exclusion from the definition of investment adviser for certain professions, including accountants; see Advisers Act, Section 202(a)(11), “but does not include...(B) any lawyer, accountant, engineer, or teacher whose performance of such services is solely incidental to the practice of his profession.” The key phrase is “solely incidental to.” Unfortunately, the Advisers Act does not give a precise definition of this phrase. The primary guidance comes from the SEC’s interpretations. In its landmark interpretation, Release No. IA-1092, the SEC put forth three tests under which a CPA could lose the exclusion. Failure of any of these tests indicates the investment advice is not solely incidental to the accounting relationship with the client. Release No. IA-1092, issued on Oct. 8, 1987, was developed jointly by the SEC and the North American Securities Administrators Association, Inc. to update Investment Advisers Act Release No. 770.

“Holding out” test: First (and arguably foremost) is the “holding out” test. Generally speaking, the concept of “holding out” is the way in which professionals present themselves to the public (e.g., marketing materials, business cards, letterhead and websites).

If CPAs hold themselves out to the public as investment advisers, they can no longer rely on the accountant’s exclusion. Most CPAs would rightfully argue they do not hold themselves out as “investment advisers.” However, as noted, the SEC’s definition of an investment adviser is very broad. For example, if CPAs hold themselves out as “financial planners” or as providing “financial planning,” they would lose the accountant’s exclusion. According to Release No. IA-1092, “[t]he staff’s view is that the exclusion contained in Section 202(a)(11)(B) is not available, for example, to a lawyer or accountant who holds himself out to the public as providing financial planning, pension consulting, or other financial advisory services.”

Taking this a step further, the SEC could potentially argue that holding oneself out as providing “estate planning” may also result in losing the exclusion (depending on the scope of the CPA’s services). Informational discussions with SEC commissioners indicate they hold this view.

“Compensation” test: The second test is referred to as the “compensation” test. Again, the SEC’s definition is intentionally broad to include any type of compensation (separately stated or not) that a CPA receives for the advice. Because CPAs are generally in the business of providing advice for a fee, this test is failed easily if part of the fee can be attributed to “investment advice.” Again, the specter of estate planning as “investment advice” could pose a significant pitfall for the CPA exclusion if billed separately.

“Specific investment advice” test: Finally, if the CPA provides advice or reports on securities “on anything other than rare, isolated and non-periodic instances,” the exclusion is lost; see Release No. IA-1092(iii):

“[S]pecific investment advice” includes a recommendation, analysis or report about specific securities or specific categories of securities (e.g., industrial development bonds, mutual funds, or medical technology stocks). It includes a recommendation that a client allocate certain percentages of his assets to life insurance, high yielding bonds, and mutual funds or particular types of mutual funds such as growth stock funds or money market funds. However, specific investment advice does not include advice limited to a general recommendation to allocate assets in securities, life insurance, and tangible assets.

“But I’m Just Giving Tax Advice”

CPAs may argue the scope of their service is merely “tax advice,” perceiving some sort of inoculation from these rules. Unfortunately, there is no such special exclusion. Rather, CPAs must meet the accountant’s exclusion. There is no further, overriding concept that exempts “tax advice” from the Advisers Act. In this situation, the argument should be that the investment advice is solely incidental to the tax advice. The SEC’s position on the scope of “incidental to” has traditionally been very narrow. However, in light of some recent activity, discussed below, the SEC appears to have broadened its position on excluded services.

Effect of Losing the Accountant’s Exclusion

Due to the nature of the wording of the statute and the SEC’s interpretations, a single member of an accounting firm can cause the entire firm to lose the exclusion. Further, once lost, the exclusion is difficult to regain. Arguably, purging marketing materials of the words “financial planning” and avoiding any of the “investment advice” services could restore the exclusion. However, this requires the collective action of all firm members and then a burdensome maintenance and oversight function.

The concepts of Release No. IA-1092 have never been formally issued as enforceable rules or orders. Release No. IA-1092 still remains the only SEC position statement on these issues. Further, the SEC has pursued limited actions against CPAs in this area. Regardless, CPAs are held to a high ethical standard under which they would never knowingly violate any law. Of course, the consequences for willfully ignoring the provisions of the Advisers Act and SEC rules are rather severe. According to Release No. IA-1092, “[a]ny person who willfully violates any provision of this subchapter, or any rule, regulation, or order promulgated by the Commission under authority thereof, shall, upon conviction, be fined not more than $10,000, imprisoned for not more than five years, or both.”

SEC “No-Action” Letters

The SEC will issue “no-action” letters (much like IRS letter rulings) to specific firms and individuals based on their particular facts and circumstances. A few no-action letters have been issued to CPAs, providing them with some relief from the narrow interpretation of Release No. IA-1092.

However, a careful reading of these no-action letters reveals that the accounting firms’ activities (such as financial planning) were to be supervised by the firm’s captive registered investment adviser firm. The SEC emphasized the importance of this oversight in granting the no-action. (Much like letter rulings, no-action letters cannot be relied on by anyone other than the recipient.)

Why Is This Relevant Now?

Most of the SEC activity in this area took place in the late 1980s and early 1990s. So, why would this issue be of concern now? Recently, the SEC has been closely examining the “solely incidental to” rule as it relates to broker-dealers. For example, Section 202(a)(11)(C) of the Advisers Act provides an exclusion identical to the accountant’s exclusion in Section 202(a)(11)(B). The exclusion is sometimes referred to as the “Merrill Lynch” rule. Under a recent ruling, the SEC broadened the definition of “solely incidental to,” thereby providing brokers with an exclusion based largely on titles (e.g., the use of the phrase “financial adviser” or its derivatives) or on the degree of control the professional has over a client’s assets.

The AICPA’s Personal Financial Planning Executive Committee (PFPEC) has been closely monitoring and meeting with the SEC on this broker issue. In the course of these conversations, the PFPEC has questioned the SEC’s interest in applying similar concepts to the accountant’s exclusion as a means of “moving the line” to clearly delineate further traditional CPA services barred by the accountant’s exclusion from investment advisory services.

The SEC has ordered a study of the entire regulatory framework for the financial services industry. The PFPEC is carefully monitoring the SEC’s activities, even though the SEC will not likely address the specific issues relating to the accountant’s exclusion as part of this initial review.

Conclusion

In providing advice for clients, CPAs should bear in mind that:

1. The SEC’s definition of investment advice is very broad and includes many services CPAs would consider to be estate or tax planning (an exhaustive list of examples is beyond this column’s scope, but the exhibit provides a few).

2. The “accountant’s exclusion” is much more fragile and narrow than most CPAs believe. An action by even one member of a firm can jeopardize the exclusion for the entire firm. Once lost, the exclusion is difficult to recover.

3. Whenever CPAs provide clients with tax planning services related to securities (as broadly defined), they must very carefully restrict their advice to tax issues. Further, they should clarify this restriction in writing.

The PFPEC will provide further guidance to AICPA members in the coming months as a means of helping them identify the risks and developing a better understanding of the Advisers Act and SEC guidance.